4 reasons to amend your tax returns

The IRS allows taxpayers three years to claim additional refunds

Earlier this month, my colleague Jonnelle Marte explained how to correct your tax filing with an amended return. As the IRS explained, sometimes you don’t have to bother amending -- the agency will essentially do it for you. But there are times you really should go out of your way to amend tax returns.

First let’s dispel a misconception held by many people: The IRS only has three years to audit your tax return after you file.

Four Reasons to Amend Your Tax Returns

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You may have filed your taxes but that doesn't mean you won't have to look at them again this year. As MarketWatch's Jim Jelter explains, there are times you really should go out of your way to amend tax returns. (Photo: AP)

That only applies in routine cases, where the information on the tax return is, for the most part, correct. However, if you have reported far too little income, or made up way too many expenses, the IRS has up to six years to audit you. The magic number here is 25%. When you understate your tax liability or your income by 25%, you’ve just given the IRS a full 6 years to circle back.

And, if you deliberately submitted a fraudulent tax return, there is no statute of limitations on when the IRS can open your file. Of course, it’s a bit harder to prove deliberate and willful actions. But the IRS has a list of objective behaviors to draw up that can help in court.

What’s the point of all this? A major error will not just go away in three years. You’re better off correcting innocent mistakes yourself than to lose sleep for six years hoping you won’t get caught – or that your ex (spouse, best-friend, assistant, etc.) doesn’t turn you in. That’s right: The main way that the IRS catches people in this situation is via snitches.

Incidentally, although the IRS has a long window to come after you – you only have three years after filing to submit an amended tax return. After three years, you won’t be able to get a refund if the IRS owes you money.

OK, so when should you amend? There are over 100 million taxpayers in the naked country. These are just a few common stories.

1) Filing Early — You wanted your refund, so you filed your tax return before all your K-1s, 1099s or other outside information showed up in the mail. When the K-1s finally arrive, the income is much higher than you reported. Or the 1099-Bs are showing substantial securities sales. You might have had losses on all those sales. The IRS won’t know that until you tell them. The IRS computers will probably pick up the additional income. But, they won’t pick up additional losses on some of those K-1 lines that might reduce the income. Leaving this up to the IRS to revise for you, you’ll end up needlessly paying extra tax.

2) Disasters — When you filed, you were reconstructing records and data after a disaster -- fire, flood, earthquake, divorce, business split, etc. You made, what you thought were reasonable estimates of your income and expenses, but when you finally gathered all the information from clients, vendors, banks, etc., you learned that you either overstated your net profits -- or understated them substantially. Now, you have evidence to support your case.

In the case of lower profits, certainly file an amended return to claim your refund immediately. However, if your profits are higher? It’s up to your conscience whether or not you report the increased income. Ethics suggest that you should.

Incidentally, in disaster situations, you will find yourself able to reap major refunds, especially if your insurance had a substantial deductible. In the case of presidentially declared disaster areas, you may even be able to get a refund by amending the tax return for the year before the disaster. Read IRS Publication 584 for more information about Casualty Losses.

3) Protective Filings — This year, the Supreme Court will be ruling on two cases that relate to the Defense of Marriage Act. If they support same-sex marriage on the federal level, that will open the floodgates to claims for tax refunds. Same-sex couples (or survivors after the death of a partner) can file amended returns on income taxes, gift taxes, and most of all, estate taxes.

This technique doesn’t just apply to same-sex couples or the Supreme Court. You might have a situation pending in any court. Or you might be waiting for the IRS rule on a private letter ruling. Or you’re in the middle of a nasty divorce and need documents to prove you don’t owe some tax.

You can see that you’re getting close to the three year deadline to file for a refund, without having the clear information you need. That’s a good time to file a protective claim. It tells the IRS that you want your money back – but you’re still waiting for additional proof about your right to the money. That protective filing will hold your right to that refund until you resolve the issue.

4) Losses from theft or worthless stock — Normally, you may only amend for three years to claim a refund. But theft is the only category of losses that allows you to file a claim for a refund for 7 years. Quite often, even after a robbery, you don’t notice everything that is missing immediately. You may notice the most obvious things. Then a year later, you try to use something (jewelry, a tool, whatever) that you haven’t used in years – and it’s simply not there.

Or, you made an investment and the promoter or managers have been stringing you along for years. Suddenly, you realize your investment is worthless. Nothing but smoke and mirrors behind their promises – you’ve been robbed.

In these cases, you must file a police report – or add to an original report. If you know who the culprit is, especially in securities situations, you must be willing to file criminal charges in order to get the benefit of the theft-loss rules.

Why are the theft-loss rules important for worthless securities? Because if you can prove a theft loss, you can not only amend for up to 7 years, you can also claim the loss as a casualty loss. That means you deduct the whole loss on that tax return. Any loss in excess of your income can be carried over to the next return and reduce that income. The IRS explained how to get this benefit after the Bernie Madoff debacle.

Otherwise, your loss is a capital loss. Your deduction is limited to $3,000 per year over your capital gains. It could take a long time to recover those losses via tax refunds.

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